World Affairs

Michael Spence

Michael Spence, a Nobel laureate in economics, is Professor of Economics at NYU’s Stern School of Business, Distinguished Visiting Fellow at the Council on Foreign Relations, Senior Fellow at the Hoover Institution at Stanford University, Academic Board Chairman of the Fung Global Institute in Hong Kong, and Chair of the World Economic Forum Global Agenda Council on New Growth Models. He was the chairman of the independent Commission on Growth and Development, an international body that from 2006-2010 analyzed opportunities for global economic growth, and is the author of The Next Convergence – The Future of Economic Growth in a Multispeed World.

MILAN – I have just had the privilege of speaking at the main annual conference of Germany’s Economic Council, the economic and business arm of the Christian Democratic Union, the current governing party. Chancellor Angela Merkel and Finance Minister Wolfgang Schäuble were among the other speakers. It was an interesting event – and, more important, an encouraging one.

It seemed clear that Germany (or at least this rather large gathering of government, business, and labor leaders) remains committed to the euro and to deeper European integration, and recognizes that success will require Europe-wide burden-sharing to overcome the ongoing eurozone crisis. The reforms in Italy and Spain are rightly reviewed as crucial, and there appears to be a deep understanding (based on Germany’s own experience in the decade and a half following reunification) that restoring competitiveness, employment, and growth takes time.

Greece has no good options, but a serious contagion risk remains to be contained in order to prevent derailment of the fiscal and growth-oriented reforms in Italy and Spain. In the face of high systemic risk, private capital is leaving banks and the sovereign-debt markets, causing governments’ borrowing costs to rise and bank capitalization to fall. This in turn threatens the functioning of the financial system and the effectiveness of the reform programs.

Thus, the central European Union institutions, along with the International Monetary Fund, have an important role to play in stabilization and the transition to sustainable growth. Their efforts are needed to bridge the gap created by the exodus of private capital, thereby enabling the reform programs to be completed and begin to take effect. The IMF’s role reflects the huge stake that the rest of the world – advanced and developing countries alike – has in Europe’s recovery: it is a high-return investment.

All of this seemed to me to be well understood among German politicians and business leaders. Moreover, this kind of support is and should be conditional on the extent of the reforms carried out in Italy and Spain, the eurozone’s third- and fourth-largest economies, respectively. Labor-market liberalization in pursuit of competitiveness and growth is crucial – and remains to be implemented.

Buying time for reform to work requires socialization of short-term risk. There is no other way to keep bond yields under control and banks functioning, and there is no ironclad guarantee that the reform programs needed to do the job will be approved.

Eurobonds, viable in the longer term, are thus premature, because they imply a relaxation of conditionality, thereby weakening incentives to implement reforms. But if it all works, sharing risk now will not be expensive in the end. It might even yield a positive return.

What, then, of the much-discussed conflict between austerity and growth? I believe that it is based on a fairly serious misunderstanding. For Germans, austerity, in the form of sustained wage and income restraint, was an important part of the growth-oriented reforms that their country completed in 2006. Much time and effort was devoted to ensuring that the considerable burden of restoring flexibility, productivity, and competitiveness was shared equitably across the population.

But, on the receiving end of the message in southern Europe (and across the Atlantic), “austerity” is interpreted largely in fiscal terms – as an excessively rapid and potentially growth-destroying drive to cut deficits faster than the economy can structurally adjust and fill the gap in aggregate demand. In other words, harsh austerity is being viewed largely through a Keynesian lens.

Finding the right balance between excessively rapid and dangerously slow deficit reduction is important, and not all that easy. But that is just one component of rebalancing. Growth is essential to bringing down public debt/GDP ratios, and thus is a key part of fiscal stabilization. And it is true that the benefits of deficit reduction, if achieved too fast, will be more than offset by the negative effect on growth.

At the same time, to restart an economy’s growth and employment engines, other measures are needed, and vary somewhat across countries, owing to different initial conditions. But they generally include removing rigidities and other barriers to competition in labor, product, and service markets; investment in skills, human capital, and the technology base of the economy; and rebuilding safety nets in ways that promote and support, rather than impede, structural adjustment.

These reforms require the sacrifice of certain kinds of protections, as well as of income and consumption growth. The benefits come in the form of sustainable patterns of growth and employment in the future. Discipline and austerity thus entail inter-temporal and intergenerational choices about the price to be paid now – and how fairly that burden is to be borne – for greater economic opportunity and social stability in the future.

After all, restoring stability and growth is only partly about reviving short-term aggregate demand. It is also about structural reform and rebalancing, which comes at a cost. Achieving a sustainable pattern of growth requires choices that affect not just the level of aggregate demand, but also its composition – for example, investment versus consumption.

Whether one calls this austerity or something else is a matter of semantics. But the confusion that has resulted is anything but harmless. On the contrary, it has become a major impediment to a common understanding of current challenges, and thus to achieving a broad consensus on the right path forward – one with well-defined and differentiated responsibilities – in confronting them.